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Wednesday, June 23, 2010

Risk in adversity

Yesterday's Budget was always going to be tough, but was it the right thing to do?

When we started out a few years ago we stated in our manifesto that we supported a cut in the size of the state from 42% of GDP (at that time) to below 30%, i.e., a cut amounting to 12% of GDP over the lifetime of a parliament. The Tories are now proposing a 15% GDP cut, albeit from a much higher starting point, so in theory we should be pleased.

However, when we made these proposals there was scope to cut without too many adverse effects. The private sector could have picked up the slack and employment would not have been unduly affected. Doing it now means job losses with a severe lag in terms of employment picking up again. We are also at a critical risk of a double dip recession and this Budget probably adds to the risk rather than reduces it (and in a further recession the deficit will go up, not down). So the direction of policy is right in principle but the country has got into such a state that a double dip recession may wipe out the potential benefits and this Budget amounts to a big gamble.

There were some interesting things to note, such as the Capital Gains Tax rate being set at 28% rather than the 40% that some were calling for. 28%, the Treasury advised, is the rate which will maximise revenue - an example of the so-called 'Laffer effect' in operation where higher rates lead to more avoidance or reduced economic activity. We are slightly sceptical that the Treasury's economic modelling is that precise but at least the explanation is consistent with our views. It does make a refreshing change to see a decision based upon the real outcome.

As to the question of reform, the Chancellor has not changed too many fundamentals but there is possibly a good explanation for this. Many reforms cost more in the short term in order to get the longer term benefits and the room for manoeuvre is very limited right now. There are reviews happening in welfare and public sector pensions so the implementation of reforms in these areas will not come about for a while in any case. But in principle we would always favour welfare reform (changing the way welfare works to give greater incentives) rather than a simple programme of cuts.

We are very unhappy that NHS spending is ring-fenced while other departments are set to be scaled back by 25%. This is pure politics and undermines all of the talk about hard choices. The NHS has received massive increases in spending year upon year and it is only right that it should be subject to the scrutiny applied to all other areas of government.

Some of the spending decisions announced so far are also highly contentious. One example is the decision to drop the £80 million loan to Sheffield Forgemasters. This was part of a £140 package, including commercial loans, to build a 15,000 tonne press, one of very few in the world capable of making ultra-large forgings for the nuclear industry. It was a loan to be paid back at 3.5%, not a grant, and for expansion rather than a bailout for failure, thus an unusual example of the government not throwing money down the drain. Now the plant may never be built and the business will go to South Korea and Japan.

Meanwhile, the government is happy to pour subsidies into wind turbines (to the tune of £400 million last year). Could the Liberal Democrat hostility to nuclear energy have something to do with Danny Alexander's decision to axe the loan to Sheffield Forgemasters?

Our manifesto argues that we should focus spending on infrastructural benefits and encourage the development of high tech industries. Here was a test case and the government has failed.

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Risk in adversity